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Basel II Implementation

11th December 2006  Warren Edwardes interviewed by John Ferry, Risk Magazine on Bsel II Implementation

Basel II or The New Accord is certainly changing the banking landscape and will also have an impact on the real world. Up to now there has been a “one size fits all” approach to the capital backing required for risk. Capital allocation is now more sensitive to risk in all its guises. In investment management it would be unthinkable if investments or projects of different risks were treated equally in terms of determining the required return. Under Basel II Lending now falls into line with Investment principles.

If there is to be no change in overall capital backing in the system inevitably there will be a shift to quality. And a shift to Aaa rated securitised assets. The ratings on many of these structured products are going to come under much greater performance scrutiny. Of course no Aaa asset ever goes bust. It just gets downgraded and then goes bust.

Poorer credits and countries will have to pay more for financing. And banks without state-of-the-art risk management tools, now including now statistical data mining, collection and analysis, and without appropriate staff who know how to operate and interpret the results will be at a disadvantage. So the more sophisticated risk measures required for better capital treatment advantage the large global banks that are able to implement them. And because developing or even smaller countries generally do not have these banks Basel II will disadvantage firms in weaker countries and restrict their access to credit and will make it more expensive. It can be argued that a Malaysian or Eastern European Bank lending to a local firm is less exposed to risk than it is in lending to a Western present day “Enron”. But as the ratings used are US-centric there will be a shift to “quality” in the rating agency sense. Risk depends on your perspective and understanding.

But it can also be argued that a better understanding of risk and interpretation of data allows banks to lend to weaker firms, albeit at a higher rate until they establish a good credit history. Such firms may currently be excluded from the banking system or required to put up quality assets as security. When there were interest rate controls and quantitative limits on lending during the UK’s Special Supplementary Deposit scheme in the late 1970’s, “The Corset”, there was a shift to quality.

Also if everybody’s sophisticated models forecast an economic downturn will everyone jump and downgrade credit and reduce lending at the same time? Lending will be continually re-priced so will resemble markets where movements are triggered and exaggerated by momentum models. This sounds fine as being more realistic in terms of risk and reward. Except if loans are pulled the impact on industry is more than a crash in stock markets. And bank shareholders will find bank shares more volatile.

Other global banks, banks will specialize in towards businesses reflecting their ability to understand and manage risk. And disintermediation will accelerate with banks creating assets and selling them off to be held by others.

Warren Edwardes


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Warren Edwardes <note  spelling of edwardes> is ceo of Delphi Risk Management a London based banking innovation and risk consulting firm. He is author of best seller "Key financial instruments: understanding and innovating in the world of derivatives" which includes an appendix on Islamic Banking.  http://dc3.co.uk/kfi

Delphi Risk Management: Delphi creativity Delphi communication & Delphi control are the Innovation, Communication & Risk Management arms of Delphi Risk Management Limited 

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